In a prior article, we discussed the benefits of issuing stock options as part of an employee compensation package and outlined common pitfalls for entrepreneurs to avoid when implementing a stock option plan. A stock option plan is a valuable compensation tool because it ties the employees’ compensation to the company’s success. However, entrepreneurs should know that alternate compensation plans are available to accomplish this goal. One such plan is a phantom stock plan and the closely related Stock Appreciation Rights (SARs).This article aims to explain phantom stock plans and highlight a few of the advantages of to this approach to employee compensation.
Phantom stock is a compensation plan that bestows upon the holder the right to receive a cash payment at a specified future point in time usually in conjunction with a specified future event or milestone. The amount of the cash payment is linked to the market value of a predetermined number of shares of the company’s stock.
There are two main types of phantom stock plans:
- Appreciation Only Plans pay an amount equal to the value of the growth (if any) of the company’s share price over a predetermined time period.
- Full Value Plans include the underlying value of the stock, and thus pay out considerably more to the employee on a per-share/unit basis.
Phantom stock is similar in many ways to a cash bonus deferred until the future. However, typically the payout is much bigger than an annual bonus, and the award is usually contingent upon the phantom stockholder’s continued employment with the company. Occasionally the plan will have a conversion feature that issues actual stock in the company in lieu of the cash payout, if the employer so chooses.
Stock Appreciation Rights (SARs) operate much like phantom stock plans with a few key differences. Unlike “full value” phantom stock plans, SARs do not offer employees the value of the underlying stock in the company. The employee only receives cash equal to the increase in the stock price from the date of the grant to the date of the exercise. If the stock price does not increase, the employee receives nothing. In addition, although both phantom stock and SARs typically have a vesting schedule attached, SARs recipients can usually exercise their rights whenever they choose after the schedule is complete whereas phantom stock holders typically receive their payout dependent upon the company meeting certain contingencies or milestones defined by the plan.
Five Advantages of a Phantom Stock Plan
- All the financial benefits of ownership for the employee without all the risks
- Structure can motivate employees to accomplish company specific goals and
- Employers share the economic value of the company without sharing ownership control
- Less administration than a traditional stock option plan
- Tax and accounting implications
1. All the financial benefits of ownership for the employee without all the risks
Phantom stock plans are also called “mirror stock” or “shadow stock.” From the employee’s perspective, the potential financial reward of participating in a well-designed phantom stock plan will mimic the payoff of holding actual equity or options. Just like actual shareholders, holders of phantom stock have more than just a job and a paycheck to keep them focused on the company’s future success, especially if payout terms are tied to long-term company performance.
The greatest benefit of phantom stock from the holder’s perspective is many of the risks and liabilities ordinarily incurred by those with direct, legal equity ownership are avoided with this pseudo version of company stock:
- First and foremost, the employee is not required to infuse cash into the business to purchase stock or exercise options.
- Since they do not actually have any ownership interests, holders are not exposed for corporate governance issues.
- Similarly, they are not required to personally guarantee company debt.
Phantom stock plans offer only upside opportunity.
2. Structure can motivate employees to accomplish company specific goals
Most businesses today are not on a path to go public. Employees granted stock or stock options lack a liquid marketplace to sell their shares, which takes some of the appeal out of a traditional employee stock option plan. Phantom stock plans have the flexibility to define the contingencies that trigger a payout. Phantom shareholders are not dependent upon an IPO to see a reward, and the contingencies can be defined in such a way to motivate phantom shareholders to meet key company goals.
3. Employers share the economic value of the company without sharing ownership control
Phantom shares are not subject to any of the statutory shareholder rights set forth under corporate law. The rights of phantom shareholders are limited to those rights defined in the phantom stock plan. While the plan can dictate that holders phantom stock receive voting rights, typically they do not. Thus, the full authority for company decision-making remains with the actual shareholders, which typically include the company’s founders. Additional shareholders add complexity to the decision making process, which can prevent the company from acting quickly to capture key opportunities and react appropriately during times of hardship.
4. Less administration than a traditional stock option plan
The issuance of phantom stock is considered a non-qualified benefit. As such, much of the paperwork, restrictive rules and reporting requirements affiliated with traditional qualified benefit plans can be avoided. Thus, implementing a phantom stock plan should cost less in legal and accounting fees than implementing more traditional plans.
Internal Revenue Code section 409A governs a variety of deferred compensation plans, including phantom stock, and sets restrictions with regard to payment and timing. As a form of non-qualified deferred compensation, the liability associated with a phantom stock plan must be accounted for on the company’s balance sheet to recognize its obligation to the plan’s participants.
5. Tax and accounting implications
When actual stock is issued in exchange for services the recipient must recognize taxable income, just like W-2 wages. Employees granted stock or stock options are often disillusioned when they learn that they must either pay the fair market value of their shares or face taxable income.
Unlike actual stock, phantom stock is non-taxable until the cash is paid. At that point, the payment generates ordinary income for the holder of phantom stock while simultaneously generating a deduction for the company.
The information provided here is for educational purposes only and is not intended as tax advice. Oxford Valuation Partners does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Oxford Valuation Partners assumes no responsibility for the tax consequences to any investor of any transaction